Waddell & Reed

Portfolio Perspectives

Managing risk, seeking opportunities as markets evolve

Story Highlights

  • We do not think the U.S. economy has yet proven it is self-sustaining.
  • We think more normal ERP levels mean we can start reducing risk in the Fund.
  • We continue to invest in gold as a hedge against future monetary policy mistakes.
  • We see opportunities to participate in the rising prosperity of Asia’s emerging middle class.
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Investment Team

Michael Avery

Co-Portfolio Manager

Ryan Caldwell

Co-Portfolio Manager

We continued to focus on the Fund’s allocation to equities as the summer unfolded, further diversifying the portfolio while reducing that allocation. The Fund now has about 67% of its assets in equities, less than recent levels, and about 23% in cash, which is substantially more than the prior quarter. We intend to be opportunistic with the cash position going forward, looking for one-off situations or valuations that we consider attractive at the company, sector or country level.

As we explained earlier this year, we are working to reduce stock-specific risk and have focused on diversification and more exposure to certain security characteristics. In our view, equity presented the best risk/reward profile of any major asset class, even during the volatile period of 2010-2011. We anticipated that risk would begin to be “re-priced” when investors began to focus on the risks embedded in high-quality fixed-income securities and when confidence in a return to growth began to increase. Based on the increase in valuations in U.S. equities in 2012 and so far this year, it appears those changes are beginning to happen. As risk is re-priced, we think there will be fewer options for the Fund to find potential advantage.

Equities and the economy

It also appears that many investors are beginning to believe the U.S. economy is at a transition point and no longer requires the continued stimulus of the Federal Reserve (Fed). Among other things, we think this position requires confidence that U.S. economic growth will be faster than 2% and that growth will increase in the second half of this year. We do not think the economy has proven to be at that point yet.

In addition, equity markets have reacted negatively to statements from the Fed about a potential “tapering” of its bond-buying program, and thus a reduction in stimulus. The market response may be an indication that equity markets overall have come to rely on the ongoing stimulus from the Fed to support valuations.

We also think there are a variety of factors that could affect consumer spending, which drives much of the economy, and thus will affect the potential for a self-sustaining economy. For example, upward pressure on interest rates takes away some of the sustainability of an economy that is interest-rate sensitive, and higher rates tend to diminish the prospect of home refinancing to reduce costs or support other spending. In addition, rising energy prices have created an impact on consumers at the pump.

In looking at equity prices, we note that equity risk premiums (ERP) around the globe generally have moved down to more normal levels as valuations have risen. All other factors being equal, a high ERP is attractive and shows investors are risk averse, which we think creates better opportunities for us as portfolio managers. Low ERP readings indicate that equity is being priced more richly and that investors demand less in return for every dollar they invest in equities.

We think the normalization of the ERP has presented an opportunity to start moving the Fund to a lower risk position from where it has been over the past few years. With ERPs coming down, we think we’re entering a period in which our return expectations also are starting to come down.

We also do not believe there will be a massive movement of investments out of fixed income into equities. Some investors may be willing to allocate a portion of their portfolios back to equities because fixed-income returns have been disappointing while equity returns (notably as represented by the S&P 500 Index) have been strong. While we do not expect a “great rotation” from one asset class to another, as has been forecast, we do expect to see some investors chase recent performance.

In summary, we think it is increasingly difficult to advocate a major allocation to equities at this time. This does not mean we are anticipating a significant decline in equities. In our view, the “easy money” has been made in equities and we think it will be more difficult from here, requiring careful security selection, risk management and attention to actions of policy makers worldwide. We believe it is prudent — as stewards of investor capital — to take a step back on risk now and be a little more protective of capital and opportunistic with cash.

A viewpoint on gold

The Fund continues to invest in gold, based on our view that aggressive monetary policy should cause investors to prefer owning a hard currency — such as gold — rather than fiat currencies that are susceptible to a loss of value. We also think the cost of production generally should provide a floor for the gold price. That’s because as the price of gold falls below the cost of production, miners would halt production, rationing demand for existing supplies until prices rise enough for profitable production to resume.

It is possible that we have witnessed the turning point for monetary policy, but we are not convinced that there has been a change. While the discussion has turned to tapering stimulus measures, the actions of the majority of monetary and fiscal policy leaders indicate that they believe the remedy for economic weakness is loose monetary policy, lower interest rates and aggressive policy action, such as the quantitative easing that has taken place around the world in the past few years. We thus continue to invest in gold as a hedge against possible policy mistakes in the future.

Maintaining a long-term theme

One of the Fund’s central themes continues to focus on the growth in consumer consumption from the expansion of the middle class in emerging markets. We have specifically focused on the populations across Asia. There has been considerable speculation in the media and among market participants about slowing growth in real gross domestic product in that part of the world.

However, we believe that there are select opportunities to participate in the rising prosperity of individuals across Asia who generally are referred to as middle class.

We have focused on companies that we believe can grow their businesses and profitability even with less robust emerging market growth. Our long-held positions related to gaming in Macau provide a good example.

We’re now looking at a bull market in equities that has reached more than four years and a multi-decade bull market in fixed income. In considering investment options from here, we think it is important to analyze where economic growth will come from in the future and think carefully about what expectations are priced into the markets.

Past performance is no guarantee of future results. The opinions expressed are those of the Fund’s portfolio managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through Aug. 23, 2013, and are subject to change due to market conditions or other factors.

Risk factors. As with any mutual fund, the value of the Fund’s shares will change, and you could lose money on your investment. The Fund may allocate from 0 to 100% of its assets between stocks, bonds and short-term instruments of issuers around the globe, as well as investments in precious metals and investments with exposure to various foreign securities. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Fixed-income securities are subject to interest-rate risk and, as such, the net asset value of the Fund may fall as interest rates rise. Investing in high-income securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. The Fund may focus its investments in certain regions or industries, thereby increasing its potential vulnerability to market volatility. The Fund may seek to hedge market risk on various securities, increase exposure to various markets, manage exposure to various foreign currencies, precious metals and various markets, and seek to hedge certain event risks on positions held by the Fund. Such hedging involves additional risks, as the fluctuations in the values of the derivatives may not correlate perfectly with the overall securities markets or with the underlying asset from which the derivative’s value is derived. Investing in commodities is generally considered speculative because of the significant potential for investment loss due to cyclical economic conditions, sudden political events, and adverse international monetary policies. Markets for commodities are likely to be volatile and the Fund may pay more to store and accurately value its commodity holdings than it does with the Fund’s other holdings. These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers.

Diversification and asset allocation do not ensure a profit or protect against loss in a declining market. They are methods to help manage risk.

The S&P 500 Index is an unmanaged index of common stocks that generally is considered to represent the U.S. stock market. It is not possible to invest directly in an index.

Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus, or if available a summary prospectus, containing this and other information for the mutual funds offered by Waddell & Reed, call your financial advisor or visit us online at www.waddell.com. Please read the prospectus or summary prospectus carefully before investing.

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